The last substantive update on the Volcker Rule came from the WSJ a few weeks ago. The article contains an interesting — though not altogether surprising — nugget, which highlights one of the key issues in the proposed Volcker Rule. From the WSJ:

The SEC and a trio of banking regulators are butting heads over how to define the buying and selling of securities on behalf of clients, known as market-making, as well as over banks’ ability to invest in outside investment vehicles such as hedge funds, according to officials close to the discussions. Since brokers, which are overseen by the SEC, conduct market-making activities, the SEC is pushing for more influence over the issue, these people said.

So it’s the SEC vs. the banking regulators, and apparently on multiple fronts.

This divide makes sense with regard to the market-making exemption — the proposed Volcker Rule’s market-making exemption leans heavily on the SEC’s existing definition of “market maker.” In order to claim the market-making exemption, the bank’s trading activity must meet the proposed rule’s definition of “bona fide market making,” and the proposed rule explicitly states that “the Agencies expect to take an approach similar to that used by the SEC in the context of assessing whether a person is engaging in bona fide market making.” So it’s not hard to see why the SEC would be pushing for more influence over this issue.

However, the Volcker Rule’s market-making exemption will need to apply to a much larger range of financial products and markets than the SEC has ever had to apply its “market maker” definition to. Because all these markets have varying levels of liquidity, different trading infrastructures, etc., bona fide market making will look different in some markets than it does in others.

To address this, the proposed rule divides the universe of markets into (1) “relatively liquid” markets and (2) “less liquid” markets, and then broadly describes what legitimate market-making should look like in each.

Whether a particular market is put in the “relatively liquid” or “less liquid” bucket will matter a great deal, as it will be much easier for banks to claim the market-making exemption in less liquid markets. For example, in less liquid markets, banks will not have to demonstrate that their trading in that market “includes both purchases and sales in roughly comparable amounts” in order to claim the market-making exemption, which they will have to demonstrate in more liquid markets. In addition, in less liquid markets banks will not be required to “mak[e] continuous quotations that are at or near the market on both sides,” which, again, they will be required to do in more liquid markets.

So what is required for banks to claim the market-making exemption in less liquid markets? Essentially, banks just need to hold themselves out as willing to provide two-way quotes in that market on a regular basis, and be consistently active in that market. It’s fair to say that this is not hugely demanding.

Moreover, the proposed rule also states that bona fide market making in any market can include block trading when it’s done “for the purpose of intermediating customer trading.” Here, again, the proposed rule explicitly points to the SEC’s existing definition of “qualified block positioner” for guidance.

Now, it’s important to note that even within the “more liquid” and “less liquid” buckets, the regulators will almost certainly apply these criteria to each specific market differently — “as the facts and circumstances warrant,” as they say. But who gets to decide which markets go in which buckets, and how stringently to apply the market-making criteria to each market? Will the final rule add separate criteria for all the major markets, or will regulators apply the broad criteria on a case-by-case basis as questions arise.

My guess is that this is what the SEC and the banking regulators are fighting over.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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